'Four pillars' policy under fire from Productivity Commission

The "four pillars" policy that prevents big bank mergers is unnecessary and has repressed competition, says the Productivity Commission, which has called for a sweeping review of restrictions on ownership of the nation's banks.

Calling for a shake-up of Australian bank regulation, the government's top economic think tank also criticised the prudential regulator's interventions for being "excessively blunt" and holding back smaller lenders.

After years of changes aimed at boosting the big banks' balance sheet strength, the commission urged regulators to again review bank capital requirements, with a view to helping smaller banks better compete in the business and home loan markets.

The draft report of its inquiry into competition in financial services, released on Wednesday, said that since the global financial crisis, Australia's system of financial regulation had swung too far in favour of stability, at the expense of competition.

Among a suite of draft findings and recommendations, it said the "four pillars" policy that has had bipartisan backing since the early 1990s was a relic that was no longer needed, because there were other laws to promote competition.

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Moreover, the policy had protected the big four from takeovers, which was the "most direct form of market discipline" on management to become more efficient.

"While protecting competition may have been the stated objective of the four pillars policy, in practice it has protected a specific market structure above all else — one dominated by four domestic banks," the draft report said.

"It has thus had the scope to weaken the four major banks’ ability to pose a credible competitive threat to each other."

The report, however, did not suggest giving the green light to bank mergers. Instead, it argued for a 15 per cent cap on any single shareholder's ownership of Australian banks to be raised. The Treasurer must currently approve a single shareholder owning more than 15 per cent of a financial sector business, but the commission said this cap should be reviewed by the end of the year.

Treasurer Scott Morrison requested the Productivity Commission review of competition in finance, after it was recommended by the 2014 financial system inquiry led by former Commonwealth Bank chief David Murray.

The report also recommended major changes to the way the Australian Prudential Regulation Authority (APRA) sets "risk weights", which are financial models that affect how much equity capital banks must hold against loans.

In recent years, APRA has forced the big banks to use more conservative risk weights and become better capitalised, which raises their costs, and should in theory help smaller banks compete. However, the commission said it was not clear customers had benefited from the changes through lower prices.

Instead of APRA's approach, it suggested risk weights be lowered for the smaller banks, which would in effect cut their funding costs.

Such an approach may be resisted by APRA or the Reserve Bank, as it would probably result in more cheap credit being pumped into the housing market, which they have been leaning on in recent years.

APRA's crackdown on interest-only mortgage lending in recent years was also criticised for being "excessively blunt" and having a "detrimental" effect on competition, because it in effect locked in the major banks' market share.

Since early last year, banks have been forced to keep new interest-only lending at less than 30 per cent of their new home loan approvals, and banks responded to the new rules by raising interest rates for all customers with interest-only loans. The commission said the policy intervention served to not only raise the banks' profits, but also dampen competition from smaller players.

In response to "widespread" failings of competition in banking, insurance and other financial services, the commission said the government should task one of the country's top regulators - either the securities regulator or the competition watchdog - with being a "champion" of competition in financial services.